Current Economic Forecast
Real Growth in Gross Domestic Product: +2.5- +3.5%
Inflation: 1-2 %
Growth in Corporate Profits: 10-20%
Real Growth in Gross Domestic Product: +1.5- +2.5%
Inflation: 2-3 %
Growth in Corporate Profits: 7-12%
Current Market Forecast
Dow Jones Industrial Average
Current Trend (revised):
Short Term Up Trend (?) 10506-13811
Short Term Trading Range (?) 9645-11257
Long Term Trading Range 7148-14180
Very LT Up Trend 4187-14789
2009 Year End Fair Value 9440-9460
2010 Year End Fair Value (revised) 10095-10115
Standard & Poor’s 500
Current Trend (revised):
Short Term Up Trend (?) 1096-1505
Short Term Trading Range (?) 1042-1220
Long Term Trading Range 766-1575
Very LT Up Trend 644-2000
2009 Year End Fair Value 1165-1185
2010 Year End Fair Value 1240-1260
Percentage Cash in Our Portfolios*
Dividend Growth Portfolio 17%
High Yield Portfolio 17%
Aggressive Growth Portfolio 15%
*these percentages have declined as a result of portfolio appreciation
The economy is a neutral for Your Money. I for one experienced sensory overload this week. Focusing strictly on the reported data, I would characterize it as positive--not enough mind you to alter our forecast of an economy growing at a below average secular rate and likely to continue on that path; but sufficiently up beat to further distance us from a ‘double dip’. Because of investor concern over unemployment, perhaps the most important stat was the much better than expected October nonfarm payroll number along with the accompanying upward revisions in both September and August readings.
Of course, the economic indicators were a small part of the total news picture.
(1) the election results were pretty much as I had anticipated. The republicans did well enough to assure gridlock but certainly don’t have the votes to reverse any of the damage done by the democratic agenda of the last two years. As I noted earlier in the week, there is a possibility that the democratic senators up for re-election in 2012 will be sufficiently concerned about the November 2 results that they will go along with republican efforts to make fiscal, regulatory and trade policy more responsible, businessmen interpret the outcome of the elections more positively than I and begin investing and hiring at a level not anticipated in our forecast and Obama may surprise us all and actually be willing to compromise. At this point, there is no way of handicapping the likelihood of any or all of these occurring, so all we can do is wait and see. I am certainly not making adjustments to our Economic or Valuation Model on hope,
(2) the Fed delivered QE2 pretty much in line with estimates when the reinvestment of mortgage ‘run offs’ are factored in. I continue to believe that if the Fed goes ‘full bore,....the implications for currency/trade [risk a global race to ‘beggar they neighbor’/’competitive devaluation’] and inflation [higher] are negative. If this occurs, I will likely have to adjust both the secular economic growth rate [as world trade declines] and inflation numbers in our Economic Model. I reiterate: The best thing that could happen to QE2 is an early grave.’
This is so simplistic that it is scary; and it pisses me off that I didn’t think of it (short):
(3) foreclosure-gate got almost lost in the shuffle. However, this problem isn’t going away. That said, I still haven’t ‘read or heard an analysis definitive enough on the actual facts in this situation to come to any kind of conclusion; and until there is one, foreclosure-gate is simply an unquantifiable dilemma that will overhang investor sentiment until its risk can be reckoned. The bad news is that it could result in another massive assault on bank capital that further restricts management’s ability to fund economic growth. The good news is that it is much ado about nothing.’
Bottom line: the economy is in a slow, drawn out recovery which I believe (1) will almost assuredly be thrown off track by QE2 if the Fed goes through with it, (2) could be further impeded by the potential problems that could arise out of the foreclosure crisis but conversely (3) could be helped by either a move to the center by democratic senators and/or Obama or a more upbeat response to the elections by the business community than I expect. That said, I am making no changes to our forecast at this time.
This week’s data:
(1) housing: weekly mortgage applications fell 5%;
(2) consumer: weekly retail sales were positive; plus October auto sales were much better than anticipated; both September personal income and spending came in below expectations; weekly jobless claims were very disappointing while the October nonfarm payroll number was dramatically better than estimates,
(3) industry: both the October manufacturing and nonmanufacturing indices of the Institute for Supply Management were stronger than expected; September construction spending also improved more than forecast; finally, September factory orders came in above estimates,
(4) macroeconomic: third quarter productivity rose more than anticipated.
The Economic Risks:
(1) the economy is weaker than expected.
(2) Fed policy (reading the data correctly).
(3) a disruption in global oil supplies (It is not the price of oil but its availability that will cause severe economic dislocation.).
(4) protectionism (Free trade is a major positive for world and US economic growth.).
(5) fiscal profligacy (Government spending as a percent of GDP is too high and the looming explosion in entitlement expenditures will make it worse. There is no good solution save spending discipline.).
(6) a rising tax and regulatory burden (Government has never proven that it could solve economic problems efficiently or satisfactorily.)
The domestic political environment is a neutral for Your Money while the international political environment remains a negative.
Thoughts on the republican victory from Victor Davis Hanson (medium):
And Charles Krauthammer (medium):
The Market-Disciplined Investing
The Averages (11444, 1225) had a heck of a week, breaking through the 11257, 1220 resistance level on Thursday and following through with another up day on Friday. Our time and distance discipline is operative right now; but if the indices remain above the upper boundary of their current trading range (9645-11257, 1042-1220) a couple more days then my ‘hypothetically re-setting uptrend’ (10506-13811, 1096-1505) will become a reality.
Volume remained above average viz a viz recent performance; breadth weakened a bit but the flow of funds indicator is smoking; the VIX was down again and is well within its current down trend. A review of our internal indicator shows that in a Universe of 153 stocks: 69 are above their comparable 11257, 1220 level (the upper boundary of the trading range of the Averages), 61 are not and 23 are too close to call. This is not a roaring signal that the up trend will indeed be confirmed; but it is very definitely positive.
Just to remind you of the powerful technical forces propelling prices up, they are: (1) the manner in which the S&P blew through the 1149 resistance level, (2) the historic behavior of stocks after they negate a head and shoulders formation, (3) the historic behavior of stocks when they successfully complete a reverse head and shoulders and (4) the historic behavior of the third year of the presidential cycle--the strongest of the four year cycle)., (5) a break down in the technical pattern of the VIX--a positive for stocks and (6) the golden cross in the S&P and NASDAQ [when the 50 day moving average breaks above the 200 day moving average--historically a sign of higher prices].
So equities end the week in the midst of the ‘no man’s land’ that is created by our time and distance discipline whenever a trend has been challenged. We wait to see if prices retreat, re-establishing a trading range or they hold above 11257, 1220 and re-set the trend to up.
(1) short term, the indices closed the week balanced between a trading range defined by 9645-11257, 1042-1220 and an up trend marked by 10506-13811, 1096-1505,
(2) long term, the Averages are in a very long term [78 years] up trend defined by the 4187-14789, 644-2000 and a shorter but still long term [13 years] trading range defined by 7148-14198, 766-1575.
Fundamental-A Dividend Growth Investment Strategy
The DJIA (11444) finished this week about 12.1% above Fair Value (10049) while the S&P closed (1225) around 1.9% undervalued (1244). The key assumptions in our Valuation Model that define Fair Value are primarily derived from our Economic Model; and as I suggested above, nothing that occurred this week prompts me to alter either. To reiterate those factors that could force a change: (1) a sudden burst of optimism in the business community leading to an increase in capital investment and hiring, (2) a willingness among the politicians to work together to unravel the fiscal, regulatory, trade mess that we now face, (3) QE2, if the Fed goes through with this program, (4) foreclosure-gate.
Of course, at the moment, my fundamental analysis is being trumped by the technical forces described above; and given that Valuations are not at extremes, it is tough for me to assume that I know more than Mr. Market. However, if you will recall, I had the same cognitive dissonance problem when the S&P broke the 1149 level, but we put cash to work and look how that turned out.
The point being that I may not be smart enough to nail the fundamentals every time; but I am smart enough to know what I don’t know. And what I don’t know right now is why investors are pushing stocks up in a virtual Titan III formation. It may become obvious in a day, a week, a month, etc, etc but then it will be too late. Or it may be that I have the fundamentals right but the amount of cash on the sidelines coupled with the size of the existing short position and the persistent need for the hedge funds to perform (which has been marginal overall to date) before year end will keep prices soaring. That seems to be what the flow of funds (which I have referred to several times recently) is telling us.
Hence if our time and distance discipline confirms the break out above 11257, 1220, our Portfolios will reduce their cash position to between 12% and 15% while bearing in mind those risks about which I am concerned and abiding as much as possible by our Price Disciplines. (As an aside, 12-13% is probably as low a cash position as I feel comfortable with in the absence of a major change in the fundamentals.)
(1) our Portfolios will carry a higher cash balance than pre-financial crisis but it will be more a function of individual stock valuations and less on macro Market technical trends,
(2) we continue to include gold and foreign ETF’s in our asset mix because we continue to believe that inflation is the major long term risk. An investment in gold is an inflation hedge and holdings in other countries provide a hedge against a weak dollar and exposure to better growth opportunities,
(3) defense is still important.
Current 2010 Year End Fair Value* 10105 (revised) 1250 (revised)
Fair Value as of 11/30/10 10049 1244
Close this week 11132 1183
Over Valuation vs. 11/30 Close
5% overvalued 10551 1306
10% overvalued 11053 1368
15% overvalued 11556 1430
Under Valuation vs. 11/30 Close
5% undervalued 9546 1181
10%undervalued 9044 1119
15%undervalued 8541 1057
* Just a reminder that the Year End Fair Value number is based on the long term secular growth of the earning power of productive capacity of the US economy not the near term cyclical influences. The model is now accounting for somewhat below average secular growth for the next 3 to 5 years with somewhat higher inflation.
The Portfolios and Buy Lists are up to date.
Steve Cook received his education in investments from Harvard, where he earned an MBA, New York University, where he did post graduate work in economics and financial analysis and the CFA Institute, where he earned the Chartered Financial Analysts designation in 1973. His 40 years of investment experience includes institutional portfolio management at Scudder. Stevens and Clark and Bear Stearns, managing a risk arbitrage hedge fund and an investment banking boutique specializing in funding second stage private companies. Through his involvement with Strategic Stock Investments, Steve hopes that his experience can help other investors build their wealth while avoiding tough lessons that he learned the hard way.
11-06-2010 8:17 AM